China Small-Cap Bubble Seen Bursting by UBS After 43% Gain

By Bloomberg News -
May 20, 2013

Chen Li, the UBS AG (UBSN) strategist who
predicted the tumble in China’s smallest shares two years ago,
says the companies are poised to retreat again after valuations
rose to the biggest premium over larger stocks since 2010.

The ChiNext index of Shenzhen-listed companies with a
median market value of $765 million climbed 43 percent this year
through last week, while the CSI 300 Index, which has a median
capitalization of $3.5 billion, rose 2.7 percent. The smaller-company gauge traded for 4.6 times net assets versus 1.7 for the
CSI index, the widest gap since June 2010, data compiled by
Bloomberg show.

“The bubble may burst” within two months, Chen said in a
May 9 phone interview. The Shanghai-based strategist predicted
in January 2011 that small-cap stocks would drop as much as 20
percent. The ChiNext gauge fell 21 percent in nine months.

Investors will rotate out of smaller companies and into
larger stocks as liquidity tightens, Chen said.

Tightening Liquidity

China’s money-market rates rose on May 9 after three days
of declines as the central bank sold bills for the first time
since 2011, draining cash from the financial system. Aggregate
financing, a broader measure of credit that includes trust loans
and stock and bond sales, was 1.75 trillion yuan ($285 billion)
in April, compared with a record 2.54 trillion yuan the previous
month.

The ChiNext gained 2.8 percent to 1,051.65 at today’s
close. The gauge was created in 2009 as an alternative for
smaller companies seeking to raise funds and has fewer listing
requirements than the two main boards in Shanghai and Shenzhen.

The index rebounded 21 percent in the first three months of
the year, a record quarterly gain, as investors speculated its
companies will benefit the most from a December pledge by Xi’s
government to focus the economy more on domestic demand and
reduce its reliance on investment spending. The gauge fell a
combined 37 percent in 2011 and 2012.

China’s economic growth slowed to 7.7 percent in the first
three months of the year from 7.9 percent a quarter earlier.
Central bank Governor Zhou Xiaochuan said on April 20 that the
slowdown in the first quarter is “normal” as the economy
sacrifices growth to make structural reforms. Economic reports
for April showed consumer prices accelerated from the previous
month, while industrial output and fixed-asset investment grew
slower than economists had estimated.

Bullish Fund

China International Fund Management’s Du Meng is bullish on
the technology, media and alternative energy companies that
dominate the nation’s small-cap stock indexes, saying they will
benefit most from government efforts to boost consumption and to
invest in “emerging” industries.

Du, whose China International Emerging Momentum Fund (CHIEMOM) has
climbed 41 percent this year for the best performance among 785
China funds, said in an April 23 e-mail that the companies still
have higher growth potential than industries that rely on
exports and fixed-asset investment.

Of the Shanghai-based fund manager’s top 10 holdings at the
end of the first quarter, seven were small caps that trade in
Shenzhen, including Apple Inc. supplier GoerTek Inc. (002241), according
to the fund’s quarterly portfolio report. GoerTek has jumped 72
percent this year.

Movie Boom

The government is targeting 8 percent of gross domestic
product by 2015 for so-called strategic emerging industries
including information technology such as cloud computing, Steven Sun, a Hong Kong-based China equity strategist at HSBC Holdings
Plc, wrote in a June 2012 report.

Shares of Leshi Internet, a Beijing-based online video
company, have more than doubled this year after profit increased
39 percent in the first quarter. The company trades at 61 times
estimated profit, data compiled by Bloomberg show. Huayi
Brothers, China’s biggest publicly traded filmmaker, has doubled
this year after net income jumped 459 percent on the success of
movies such as the action-comedy “Journey to the West.” It
trades at 43 times estimated profit, 72 percent higher than at
the start of the year, the data show.

An official from Leshi declined to comment on the company’s
valuation when reached by phone. Three calls made to the office
of the board of directors at Huayi Brothers in Beijing went
unanswered. The filmmaker didn’t reply to e-mailed questions
seeking comment.

Earnings Outlook

Profits for all small-cap companies rose an average of 2.6
percent in the first three months from a year earlier, compared
with a 9.1 percent decline last year, according to Shenyin &
Wanguo Securities Co.

The larger companies in the CSI 300 reported average profit
growth of 9.8 percent in the first quarter, up from a 3.2
percent increase last year, according to data compiled by
Bloomberg.

“Earnings growth for small-caps are still relatively low
and don’t match current valuations,” Zhao Longlong and Kong Lingfei, analysts at Shenyin & Wanguo, wrote in a May 6 report.
“Risks exceed opportunities for some growth stocks that have
had sizable gains.”

Selling ‘Avalanche’

His view is shared by Hao Hong, the chief China strategist
at Bank of Communications Co., who predicted in a Bloomberg
Television interview on Jan. 2 that smaller companies would
outperform. He now says ChiNext stocks are a “crowded trade”
that may unwind as profit growth slows.

Chinese mutual funds allocated more than 50 percent of
their assets to small-cap stocks at the start of the year,
compared with 17 percent for larger companies, according to
BoCom estimates. Once funds pare their small-stock holdings,
others may follow and trigger an “avalanche” of sales, the
Hong Kong-based strategist wrote in a May 6 e-mail.

Small caps are “likely the most risky place to put
money,” BoCom’s Hong said. “The strong relative performance of
ChiNext is unlikely to last.”